Early investors bear enormous risks, and as ventures grow, their contribution is often forgotten.
This is a topic that came up in some conversations this week. I’m not going to add to the opinions of high profile investors and the mechanisms designed to help early investors retain participation rights through financing rounds. Instead, I’m going to share my philosophy for how I think founders should maintain respect for all investors, and particularly the few who back founders early in their journey.
If there is one take away from this post, it’s that entrepreneurship is a craft. It takes multiple efforts to build great companies. And because of this multiplicity, founders are very likely to engage with the same investors time and time again.
In this context, respect is much like trust, it is based on consistency over time. Optimise for trust and respect, then no matter the venture’s outcome and there will be room to re-engage in the future.
Choose to de-prioritise these relationships, and your chances of future engagement are close to, if not, zero.
The early days
Early stage investors are the ones who believe in you as the founder. They back you when a pitch deck and traction from a product held together by duct tape is all you have.
They are family, friends and early-stage investors and they put post-tax money at risk by backing your venture. In other words, they had to earn two dollars for the one they are investing in you.
They make a conscious decision to commit that capital but to say that ‘they know what they are getting themselves into’ is generally a huge cop-out. You can say that about seasoned early stage angel or venture capital investors but not about friends and family.
In any case, before their capital is committed to the venture, founders can be assured of two, self-reinforcing factors.
First, entering into an investor/investee relationship changes the dynamic between those two parties forever. If a startup investment provides a return or at least returns capital, that is a win. However, the more likely outcome is that every dollar will be lost. Founders need to be OK with this possibility and how it will affect those relationships.
There are two things I hate in this world. The first are bullies. The second is having to tell investors that I have lost their money. As I’ve written about before (here and here), if that time comes, the only thing that stands between you and any future relationship is the respect that has been built up over time.
The second factor is the fact that the understanding of what risk actually means will vary significantly between early-stage investors.
No one wants to lose money on their investments, but seasoned investors are more aware of the real risk of losing every dollar and the potential reputation damage that comes with early-stage investments.
Family and friends hope you will pull it off.
They think you’ll be the one or they may not fully appreciate just how much risk is involved in building something from the back of an envelope.
These two factors can be managed through repeated and candid conversations. However, there is a third one that is often only recognised with hindsight.
It’s that these early-stage investors are the same people who are often forgotten as new investors with deeper pockets enter the cap table.
Being too transactional
What I’m about to say doesn’t apply to all founders, but many will be able to relate. I believe in always being in motion on business development to identify and secure new partnerships, customers, hires and investors.
When it comes to finding new investors, it can become more of a numbers game than one of acknowledging people and the risk they are taking. That’s because founders wade through a sea of ‘No’ before they arrive at the few who are willing to engage. And as fundraising fatigue and the desperation to keep their company breathing builds, the numbers, investment terms and closing the requisite number of investors becomes the main game.
There is an unintended consequence of this focus on the current financing round which often affects earlier stage investors. In a nutshell, the risk(s) that they took, in the beginning, get traded-off against the ‘value’ that founders believe incoming investors will bring to the company.
This can play out in many ways but here are the classic hits:
Founders provide minimal communications about their venture’s progress and then deluge investors with details of an imminent financing round. The amount of context and questions that need to be asked and answered puts all parties under pressure, including existing terms like pro-rata rights, and when push comes to shove the venture’s survival is in the hands of the founder(s) and incoming investors. As a result, early-stage investors have little choice but to agree to new terms. The unintended consequences of which can be profound.
Like the Rush (above), founders share their thinking and plans to pivot the business model with those who they believe to be their most influential investors. Other investors discover later, often much to their surprise.
Founders introduce an unfamiliar financial instrument to people with limited startup investment experience and try to convince them of the instrument’s merit because the founder isn’t willing to nominate a value for their company. This can happen at the beginning of the venture or at some point in the ventures history.
Whether it be a convertible note or a SAFE (simple agreement for future equity) note, the founder is likely to claim that this is the best option due to a lack of clarity on the companies current valuation. While these notes do have a role to play, many founders don’t fully understand the intricacies and implications that can disadvantage incoming investors, future investors and the venture itself.
The classic issue with notes, particularly convertible notes, and inexperienced investors is that they often end up with less equity than they expected after the conversion event.
Because the founder either claims they cannot provide financial advice and that the investor should seek independent financial advice (which is true) or, using the previous reason, avoid discussions about specific scenarios with the prospective investor for fear of them not being comfortable with assumptions or their resulting potential stake in the company. Either way, this can leave a bad taste in the investor’s mouth.
Respecting early investors
Aside from risk, some inevitabilities come with being an early stage investor. Some of these issues can be forecast, while others fall out of regular conversations. The impact of dilution is one example which can be forecast. Even though the share price will change at each round (hopefully upwards), less experienced early-stage investors will be more concerned with dilution.
The point is that education goes a long way to short-circuiting the potential anxieties that come with uncertainty.
In this context, education comes in the form of conversations that help investors understand the current state and how the strategy is unfolding.
At the other end of the spectrum is no communication or a readily identifiable petering out of communications from the founders. This is a red flag for investors. And because this is a well-established signal that a venture may be in trouble, investors will start forming opinions in a vacuum which is often counterproductive. Especially if this issue could be solved with routine communications.
Avoid red flags with four tactics
I employ four tactics to establish and maintain respect with all, but in particular, early-stage investors:
1. Express the company’s intent – In addition to sharing the opportunity and how you plan to capture it, share how the founders (and other existing shareholders, if any) plan to engage with new investors. This might include the high-level terms (e.g. a standard shareholders agreement), the different share classes (if more than Common Shares), the pro-rata rights available to shareholders and how much capital the venture expects to raise in the next 2-3 years if everything goes to plan
2. Regular status updates via email – This is a simple monthly email update that includes six items:
- Business Update – Cash at bank, Monthly burn rate, runway (based on current burn rate) and headcount
- Our Mission – Your venture is a small part of your investors’ life, broken record style reminders are important
- Key Growth Metrics – List the key growth metrics that are being tracked (including last month’s result and a rolling three-month average to help add trend-based context to the data)
- Progress – This section talks to advancements made in customer and partner acquisition, hiring and the development of key relationships
- Challenges – These are the current roadblocks. This makes for especially good reading if investors can see that the founders are leveraging existing investors and advisory board members to solve issues.
- Next Month’s Focus
3. Strategy updates and scenario planning – These are a formal presentation and Q&A sessions done in person or via Zoom with all investors. Think of them as an ‘all hands’ meeting with investors. A pre-read is issued before the meeting and questions about the material are also requested ahead of the meeting.
This provides the team time to formulate responses. Not only does this model help to effectively respond to questions, but it also helps the team galvanise their thinking on particular issues. Pro Tip: Record the session using Zoom for those who cannot make it can listen at their leisure.
4. Ad-hoc check-in calls – I really enjoy time speaking one on one with investors. It’s an opportunity to learn more about each other. I make sure I call investors once a quarter. The timing will seam ad-hoc to them, but it’s carefully scheduled in my diary.
One last thing…
Respecting early investors is about developing a relationship to ensure intent and incentives remain aligned. I do not mean for founders to dedicate significant portions of their time to investor relations. I am advocating for setting up routines and rituals needed to keep investors informed.
Entrepreneurship is a craft. You will engage with the same early stage investors time and time again if you create respectful relationships that endure. The best way to achieve that is to give early-stage investors time and air cover to understand the benefits and implications for their ownership of the company.
They expect it and will thank you for it.